Times of economic austerity provide excellent opportunities to invest in distressed assets. Financial asset prices are usually depressed, but risk aversion means mainstream investors are wary of getting involved. In stressed or distressed scenarios, the valuation of a company’s debt securities can fall disproportionately, as funds whose mandates prevent them from holding bonds once they are in default become forced sellers. Distressed funds can derive substantial profit from purchasing securities at depressed prices which do not fully reflect the break-up value of the related business, let alone its recovery potential.

Default rates look set to rise significantly. An unprecedented amount of debt is due to mature over the next three years, which is likely to completely overshadow the availability of credit. Very few companies will be able to refinance debt through operating cash flow, so most will seek external sources of capital or simply file for bankruptcy.

It is likely that the most lucrative phase of the distressed cycle remains ahead of us. History suggests that the best returns are typically achieved after default rates have peaked. Moreover the potential rewards for distressed investors in this cycle may eclipse those seen in the aftermath of previous credit implosions. As defaults rise, the price of non-investment grade securities is likely to fall to levels that are grossly unjustified on a fundamental basis. This provides the ability to generate attractive, asymmetric returns, with limited downside and much greater prospective upside.

Europe offers the greatest opportunities. Distressed investors have historically tended to focus on the US market. But given the stress being experienced by countries in Southern Europe, and the exposure of European banks to sovereign debt, there is likely to be an abundance of opportunities for distressed investors across the continent. It has been suggested that a Greek default would inevitably cause a domino effect across other EU constituents and their banking systems. Similarly, any withdrawal of cooperation by the stronger economies could catalyse the contagion, rather than protecting state interests.

We are maintaining net short positioning for the time being. This reflects our view that many investors are holding back from the distressed space through fear of a recurrence of the 2008 carnage. We believe that the major opportunities to capture substantial alpha on both the long and short side lie ahead of us. Nevertheless, the recent sell-off has undoubtedly created some valuation anomalies in core Europe, offering the chance to access the paper of some household names with defensive qualities at oversold prices. Similarly, we see no lack of opportunities to harness returns from short positioning: we expect corporate stress to continue to increase in the coming months and years as a result of government austerity measures, falling GDP and limited access to funding.